A Time to Sell or a Time to Re-Invest?

Mike Sluka

It’s the summer of 2021 here in Florida, and COVID-19 is hopefully on a permanent wane. “Live” meetings are replacing virtual ones. Companies are actively hiring. It seems that a sustainable reopening is finally upon us. In essence, “2021” is somewhat a euphemism for the beginning of a post-COVID business cycle.

The past 16 months have been long and hard in many ways, but looking at the regional business landscape, it appears that the negative effects of the pandemic “year” were not as deep or widespread as elsewhere. Certainly travel, hospitality and some retail revenues plummeted and have not yet fully recovered. But for most of the regional business revenue, only 2Q2020 was dramatically reduced. Recent data emerging for 1Q2021 is showing that revenues and business valuations are generally where these were before COVID-19. Whether that is due to successful business pivots, better year-round transportation weather or a high business-to-business revenue base, only deeper analysis will reveal the exact factors that benefitted this region.

Given the challenge and the result, Florida business owners might be justified in thinking that a near-term exit or sale is emotionally well-deserved and financially well-timed. The financial press is replete with stories of investor fund excesses and the high intrinsic value of pandemic-proof business models. If you don’t have to argue with a buyer over COVID-19 “adjustments”, selling valuations (projected annual cash flows) will be higher, and the insistence on deferred sales proceeds might be lower. But “multiples” (annual cash flows times a future number of years) can still be problematic if you did not simultaneously manage to reduce generic business risk factors as well.

It would be a rare business owner who managed to both weather a crisis and perfect a business model simultaneously. But astute buyers will always engage in comparison shopping to find the best company within a target industry, passing on lesser performers. So yes, I predict we will be reading about businesses being successfully sold, however, the businesses that aren’t successfully sold won’t get equal press. That’s why I always say that successful selling is not so much a moment in time but as a period of time. You will need to look at competitive benchmarking data to know if 2021 is the right time to consider selling your business or whether margins or KPIs need further improvement to qualify as a best performer.

On the other hand, let us say you are invigorated by your ability to have weathered the COVID-19 pandemic and you think now is the right time for a “pedal to the metal” expansion. You could very well be correct — if you can confidently answer the age-old scalability question. Once your company is larger than an “owner-lifestyle” business, you will encounter buyers who are looking to buy companies that can earn returns higher than the growth rates they are paying you for. To win those buyers over, you will need to show “scalability”. Buyers will want to envision this scale through their own customer base (strategic buyer) or scale that is achievable through additional capital investment (financial buyer/sponsor). Can the existing owner adopt the same theory for their own income-enhancing benefit? Yes — with an aggressive plan and a source of capital.

To be clear, business growth and scaling a business are different beasts. Revenue growth in the single digits or low double-digit percentages can often be the definition of success if margins do not erode during the growing process. Scaling up, though not subject to a uniform percentage threshold, usually targets well into double-digit if not triple-digit revenue increases, while holding cost increases to a lesser rate, dramatically improving the bottom line.

Scaling up is also a sooner-rather-than-later proposition. Professional investment fund buyers typically expect four to five years to maturity (i.e., resale). Ideally, it should be no longer than two years to scale up so that there are three years’ revenue at scale. Of course, if you are not tied into an investment fund liquidation horizon, you might think longer is OK. Just remember that it is rare to operate in an industry without competition. If a market segment produces a healthy margin, then it is being pursued daily by others. Competitive awareness will generally preclude large market share gains unless you take bold, one-time actions before your competitors.

Here are a few traditional scaling-up opportunities:

• A new product/service line emanating from manufacturing/delivery infrastructure already in place.

• A geographical market expansion for existing products/services.

• An acquisition of a like-kind business to garner more market share while eliminating duplicative costs.

Certainly, if your business was truly tested by COVID-19 and you ended 2020 close or better than your 2019 numbers, you may well have the operational skill set to undertake a sizable expansion while competitors are still navigating recovery or are weary from the journey.

I can’t offer direct guidance without knowing the specifics of your business, but financial math is the same for all – you will need to project future revenue from the scaling action for at least five years. Mockup optimistic, expected, and worst-case outlooks. Project your variable costs similarly. If the projected gross margin in all cases does not equal or exceed your present gross margin, it may not be worth the risk.

Next, project operating/fixed costs, paying careful attention to synergies. It’s good to recognize multi-product line allocation opportunities that exist, but don’t spread existing fixed costs to new revenue lines without a convincing analysis. At this point, you have arrived at what the investment world recognizes as EBIDTA (earnings before interest, depreciation, taxes, and amortization). In most cases, buyers adopt this as a common-denominator measure because debt structures and asset depreciation policies can vary from one like-kind business to another. However, in your internal modeling case, you can’t ignore interest/cost of capital because you are not just comparing, you are owning the result.

Determine what you need to borrow/invest, and estimate the annual carrying cost, assuming a five-year maturity. To be fully safe, add a 20% principal reduction as a cost to each year. If you are positive in each scenario and “expected” is well more than the present state, you have a great expansion opportunity.

To sum up, if you are interested in selling, do some upfront analysis of your competitive position, strengths, and weaknesses. An objective advisor (someone not earning a commission for selling your business) might be helpful to ascertain if a period of clean-up and improvement is necessary first to achieve a better selling price. Alternatively, if you are eager to dramatically build up your business, an in-depth forecast of various revenue scenarios, capital outlays and the cost and sources of that capital needs to be accomplished. Again, a knowledgeable advisor can make this project less time-consuming while providing some more credibility with people that will invest and lend money for your growth plan.

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